The 5 Best Index Funds to Buy

by Robert Martin | July 24, 2013 10:20 am

The 5 Best Index Funds to Buy

Any investor hunting for the best index funds out there should realize one thing: Many of the best index funds are simply some of the best funds period. Active management has had its day. While individual managers and sometimes whole teams were once the gold standard of Wall Street funds, they’re ceding more and more ground to funds essentially run by a computer and tied to an index. Indeed, as Vanguard founder and index-investing guru John Bogle said recently[1] in The Wall Street Journal,

The trend of investors moving away from actively managed mutual funds and toward passive index funds will strengthen. Index funds now account for 34% of U.S. equity mutual-fund assets. Since 2007, investors have added $930 billion to their investments in passively operated U.S. equity index funds, and they have withdrawn $240 billion from their holdings in actively managed equity funds. That’s a swing of more than $1.17 trillion in investor preferences. In the years ahead, that trend will accelerate.

As a bonus to investors, some of the best index funds — usually exchange-traded funds, but often available as mutual funds, too — also happen to be some of the cheapest. Without one or several managers doing research and taking up office space, assistants and the like, index funds are able to operate with some of the lowest expense ratios in the game. So if you’re interested in getting diversified for a song, the place to start is this look at five of America’s best index funds — funds that include the famous SPY ETF and QQQ, among others:

Best Index Fund #1: SPDR S&P 500 ETF (SPY)

The SPDR S&P 500 ETF (SPY[2]) is not just one of the best index funds to buy, but the first exchange-traded fund of all time. Oh, and it’s the biggest in assets at $178 billion. Put in context, the money invested in the SPY ETF is worth as much as Coca-Cola (KO[3]), when measured by market cap. That’s pretty impressive considering the SPY ETF merely tracks the S&P 500 Index, America’s 500-stock large-cap benchmark — something you also can get by owning the Vanguard 500 Index Fund (VOO[4]) and the iShares S&P 500 Index Fund (IVV[5]). That’s even more impressive when you consider the SPY ETF is also the most expensive of the three, at 0.09% in expenses — or $9 annually for every $10,000 invested — vs. 0.07% for IVV and 0.05% for VOO. But that small difference isn’t enough to stop SPY from being one of the best index funds. The SPY ETF has seven years on both its competitors, and not only offers great liquidity on the ETF itself, but also its options. Plus, the most important reason the SPY ETF is one of the best index funds is because it is, in essence, “the market.” Yes, that same market that only about 10% to 15% of hedge funds and roughly 30% to 35% of actively managed domestic mutual funds manage to beat each year. So if you can’t beat it, own it. Right now, Apple (AAPL[6]), Exxon Mobil (XOM[7]) and Google (GOOG[8]) are the S&P 500’s largest stocks, making them the top holdings of the market-cap-weighted SPY, as well as VOO and IVV. As a nice kicker, the SPY also yields roughly 1.8% in dividends.

Best Index Fund #2: PowerShares QQQ Trust (QQQ)

Another one of the best index funds is the PowerShares QQQ Trust (QQQ[9]), which also follows one of America’s most ubiquitous stock indices … sort of. The QQQ ETF actually tracks the Nasdaq-100, which represents the Nasdaq’s 100 largest non-financial stocks by market cap. They still represent a large percentage of the Nasdaq’s overall weighting, but not so much that one perfectly follows the other. Also, while the Nasdaq is known primarily for its technology holdings, both it and the Nadsaq-100 are far from completely tech-centric. For instance, Starbucks (SBUX[10]), content and cable provider Comcast (CMCSA[11]) and biotech firm Gilead Sciences (GILD[12]) are all held in the QQQ ETF. The PowerShares QQQ Trust — also called “The Q’s” or “The Cubes” — still provides a healthy heaping of tech, of course. Technology stocks make up about 57% of the holdings for the QQQ ETF, while consumer discretionary is the next largest at 14%, and healthcare third at 13%. Most of the top holdings are tech, too, including the top three: Apple, Microsoft (MSFT[13]) and Google. Admittedly, the QQQ ETF is something of a misfit given that it doesn’t really play to any one particular theme. But it’s one of the best index funds, as it gives investors a good diversified large-cap holding if you’re very bullish on tech stocks. QQQ charges 0.2% in expenses.

Best Index Fund #3: iShares Russell 2000 ETF (IWM)

While the SPY and QQQ primarily help you get your large-cap fix, what about small-cap stocks? After all, even Apple was a startup once, and investors gobbled up fantastic returns as it shot up from a small-cap stock to America’s most valuable company. Naturally, investors want to harness this kind of growth potential … but not everyone is comfortable trying to play these individual companies, which often fall below the media spotlight, making information and analyst coverage scarce. The iShares Russell 2000 ETF (IWM[14]) is the best index fund to fix that problem. The Russell 2000 is the most popular benchmark for small-cap stocks, and IWM is by far and away the most popular Russell 2000 ETF. The index is primarily made up of small-cap stocks — the average market cap for holdings is $1 billion — though a few fall into the midcap range of $2 billion to $10 billion. Because of the nature of small-cap stocks — namely, to be able to rapidly rise or decline in value — top holdings frequently change. Current top holdings for the iShares Russell 2000 ETF include biotech InterMune (ITMN[15]), regional bank Prosperity Bancshares (PB[16]), and software maker Aspen Technology (AZPN[17]). IWM charges just 0.24% in expenses.

Best Index Fund #4: Vanguard FTSE Developed Markets ETF (VEA)

Investors should diversify by holding companies of different sizes, as well as those that deal in different businesses, sure. But another good way to protect your portfolio is by venturing outside of the U.S. and owning international stocks. The Vanguard FTSE Developed Markets ETF (VEA[18]), which tracks the FTSE Developed ex-North America Index, is one of the best index funds for developed countries. VEA allows investors to access 1,382 companies from 23 developed economies excluding the U.S. and Canada. The majority of its holdings (62%) are in Europe, while 37% are in the Pacific. While VEA is decidedly international, its companies should be awfully familiar to most Americans. Some of its top 10 holdings include Nestle (NSRGY[19]), Toyota (TM[20]), Royal Dutch Shell (RDS.A[21], RDS.B[22]) and BP (BP[23]). Because of its very large-cap bend and positioning in developed countries, VEA isn’t exactly a growth machine. But it’s one of the best index funds since it’s a fortress of stable blue-chips — one that also yields roughly 3% in dividends annually, for those seeking income. As is the norm for Vanguard funds, VEA charges a mere 0.09% in expenses — 25 basis points less than its larger competitor, the iShares MSCI EAFE ETF (EFA[24]).

Best Index Fund #5: iShares MSCI Emerging Markets ETF (EEM)

If you’re a little more interested in achieving growth with your international holdings, forget the developed markets and consider emerging markets instead. In short, emerging markets are economies that are considered not as stable, but usually because they’re rapidly growing — countries such as China, Russia and Brazil currently fit the bill here. The iShares MSCI Emerging Markets ETF (EEM[25]) — pegged to the MSCI Emerging Markets Index — isn’t just the most popular method of getting exposure to emerging markets. At least as far as assets under management are concerned, it’s one of the best index funds in existence, currently seventh with $42 billion invested. EEM holds companies from 21 different markets, though China, South Korea, Brazil and Taiwan enjoy the heaviest overall weightings by country. That includes top holdings such as Samsung (SSNLF[26]), Taiwan Semiconductor (TSM[27]) and China Mobile (CHL[28]). EEM charges 0.67% in expenses.

Updated from Nov. 12, 2013.

Endnotes:

said recently: http://online.wsj.com/articles/john-bogle-on-the-future-of-investing-the-rise-of-the-shareholders-1404765274